China’s risky reforms

President of Eurasia Group and the author of Every Nation for Itself: Winners and Losers in a G-Zero World. David Gordon, a former director of policy planning in the US State Department, is Chairman and Head of Research at Eurasia Group.

When it comes to economic reform, China's leaders no longer believe that time is on their side. With a new sense of urgency, President Xi Jinping and his inner circle are attempting one of the most ambitious economic and social-policy reform plans in history.

But in any authoritarian country, change creates risk. Consider the scale of the proposed plans. For China to reach the next stage of its development, a much larger share of Chinese-made products now destined for Europe, America, and Japan must be sold to consumers inside China. This shift will require a big increase in local purchasing power - and, therefore, an enormous transfer of wealth from large domestic companies to Chinese households.

In addition, China's leaders appear to be on the verge of approving 12 new regional free-trade zones, which will drive competition and efficiency on a new scale in many economic sectors. They also recognize the need for further liberalization of the country's financial system, a move that will require tolerance for outright defaults on bad loans - and the anxiety and anger that comes with them.

Here, as in other areas of the reform plan, change is dangerous; but Xi has come to believe that pressing ahead is vitally important if China is to take the next crucial steps toward building a middle-class, digital-age economy. Moreover, the reforms are crucial for the Chinese Communist Party's long-term hold on power.

The leadership will also try to increase state-owned enterprises' efficiency by withholding support (and money) from those that underperform, potentially putting large numbers of workers out on the streets. And the government's steps to tackle China's heavily polluted air and water, a problem that officials can no longer ignore or explain away, will weigh on short-term growth as well.

In the past, the CCP has responded to slowing growth with a surge in state spending meant to create jobs and keep the system humming. This time, the authorities are allowing growth to slow at a measured pace, partly because the slowdown is a precondition for the kind of growth that does not depend on the state, and partly because the slowdown helps sustain demand for reform.

To accomplish these goals, Xi is centralizing power, launching a charm offensive, and cracking down on official corruption and extravagance. He is also using anti-corruption and reeducation efforts to intimidate (real and potential) reform opponents within the CCP. Finally, the leadership has created new party institutions, answerable directly to top officials, to ensure that all changes are implemented as planned.

Nonetheless, while the reforms are crucial for China's future, they are certain to produce a backlash. Some of the losers have the means to defend their interests: purged officials, companies, and industries that face new regulatory scrutiny, as well as firms forced out of business, have well-placed friends within China's enormous bureaucracy. Moreover, free-trade zones bring greater competition, including from foreign firms, which raises risks of increased unemployment and capital flight.

China's leaders have long feared publicly visible divisions within the elite, given the risk that infighting could expose sensitive secrets. Xi's proposed reforms are just the sort of changes that might have this effect.

That risk is much greater today than it was ten years ago. With hundreds of millions of Chinese now online, and other twenty-first-century communication tools available to an unprecedented number of citizens, ideas and information cross China's internal and external borders with unprecedented ease and speed. In response, the CCP continues to develop new technologies to stifle or redirect dissent; but the battle for control of China's public discourse is not one that the country's leaders can win every day for the foreseeable future, and they know it.

There are broader questions as well. The authorities appear confident that they can manage the risks generated by a gradually slowing economy. What if they are wrong? What if bank defaults pile up, creating a major credit crisis? What if unrest grows to levels not seen in many years?

These scenarios are highly unlikely in 2014. But early signals suggest that if trouble develops, the party will choose a crackdown over concessions, and there is no guarantee that party unity will hold in such a scenario.

For outsiders, the reform process also poses risks that extend well beyond the global economic fallout of a sharp Chinese slowdown. The country's neighbors, particularly Japan, have the most to fear. If reforms become broadly unpopular or expose dangerous divisions within the leadership, the government will have good reason to divert public attention from controversies at home by picking fights abroad. Frictions between China and the Philippines, Vietnam, and others in the South China Sea persist, but confrontations with Japan, including over territorial disputes in the East China Sea, are more likely to cause the most damage.

No one in power in either country wants a war, but diplomatic dust-ups between China and Japan, the world's second and third largest economies, respectively, have already taken a toll on their commercial relations. In particular, Japanese companies operating in China have sustained significant reputational and financial damage during recent episodes of trouble between the two governments.

Conflict with the United States is unlikely for the moment. At such a delicate time internally, China would gain nothing from antagonizing the US. But trouble with US allies, particularly Japan, could draw the US into a fight that it would strongly prefer to avoid.

In short, China is on the brink of large, necessary, and dangerous transformations that promise to change the country for the better - or make everything, including regional stability, much worse. The entire world has a large stake in what happens next.